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May 2023

Market Update: Caution – Signs of Recession Ahead

Key Points

  • Defensive portfolio positioning remains the best strategy
  • Consensus earnings estimates may be too optimistic
  • Income is again an important driver of portfolio performance

After one of the most challenging years in recent memory, the strong start to financial markets in 2023 has certainly been welcome. Our expectations for a recovery in the traditional 60/40 portfolio were vindicated, with both stocks and bonds posting healthy gains for the second quarter in a row. Still, for those who paid attention, the ride has been an uncomfortable one, chock full of twists and turns.

Equity markets galloped out of the gate in January, fueled by optimism that a recession would be avoided, only to sharply reverse course in February as stubbornly high inflation readings and a red-hot job market indicated that the Fed’s job wasn’t done yet and sent interest rates soaring. March was then marked by concerns about a banking crisis, though the quarter ended on a positive note, with measures taken by authorities helping reassure investors that the risk of a systemic contagion was low.

The good news is that we continue to believe the US banking system is broadly sound, and though other areas of stress may emerge in the months ahead, a financial crisis similar to 2008 is unlikely to be repeated. Government reaction has been swift, and banks today are generally in fundamentally much stronger positions than they were a decade ago. The bad news is that credit conditions have already tightened meaningfully over the last several quarters and will likely only tighten further as banks look to shore up their balance sheets.

Given this, we think a mild recession in coming months will be hard to avoid. The moderating trend in economic growth is already becoming increasingly clearer, with GDP advancing only 1.1% in the first quarter, compared with 2.6% in the fourth quarter of 2022 and 3.2% in the third. We expect growth to slow more sharply over coming quarters, as labor demand cools and the mounting weight of higher interest rates and inflation take a bigger toll on business and consumer activity. 

Heading into this year’s second quarter, the resilience of markets so far this year has been notable. The S&P 500 is up about 7%, while the investment-grade bond market is up a healthy 4.2%. Nevertheless, rising risks around the outlook are signaling us to remain cautious for now and maintain our defensive investment posture. CNR portfolios continue to be modestly underweight equities and overweight fixed income, with a focus on holding US quality assets across the capital structure.

For equities, earnings expectations remain our biggest source of concern. Although consensus estimates have come down significantly over the past several months: they are still relatively optimistic given the elevated recession risk. Indeed, current analyst forecasts continue to imply a small expansion in profits this year. That’s hard to square with what increasingly looks like an upcoming contraction in broader economic activity. Over the past four recessions, expectations for earnings – and equity prices – never reached a trough before the recession actually began.

While we do see opportunities forming to add equity exposure to portfolios in the months ahead, we recommend being patient and instead taking advantage of what the market is now offering. Bonds in particular continue to look attractive in the near term, providing some of the best return prospects in well over a decade. Although recent inflation measures have signaled easing price pressures, given the stickiness of core readings and continued tightness in the labor market, we don’t see the Fed coming to the economy’s rescue anytime soon and believe market expectations for rate cuts in the second half of the year are misplaced.

In this new regime, where interest rates stay high for longer, income is back as an important portfolio driver. The share of fixed income indexes yielding over 4% is at its highest level since 2008. Depending on your risk tolerance, income and tax needs, different strategies may be appropriate. For investors whose goals require a higher level of income and who can tolerate higher volatility, corporate or municipal high yield bonds are a good solution. For investors with lower income or short-term cash needs, high quality bonds or liquidity management strategies are offering attractive yields without having to reach into riskier parts of fixed income.

In sum, we remain happy with the de-risking steps we’ve taken in client portfolios. We continue to expect more positive returns for 60/40 portfolios in 2023. However, after a nice start to the year, markets are now facing the impact of the Fed’s rapid rate-hiking cycle, including slowing economic growth and banking sector stress. Add in debt ceiling drama in Washington and we would expect market volatility to continue in the months ahead, especially if we are right and the economy heads into an economic downturn or the banking system requires more intervention. Despite last year’s weakness, having a balanced allocation has historically been a smart way to stay fully invested in times of uncertainty, and our focus on holding high quality and income producing US stocks and bonds can help provide client portfolios with relative stability until market turbulence subsides.

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